In an Undercollateralized World

The world is undercollateralized. This is the single most important feature
of the 2011 economy. Sixty years ago, if assets were worth less than loans,
it was possible to work our way into the black. In 1950, 59% of U.S. corporate
profits were from manufacturing; 9% were from finance. The roles of manufacturing
and finance have reversed. Thus, we witness the desperate attempts to forestall
what cannot be prevented. Yet, the world must deleverage. Banks must write
off loans. Loans to bankrupt developers and companies must be called. Living
standards must fall.

The authorities are doing all they can to prevent the necessary deleveraging.
That is the context in which Michael A.J. Farrell, CEO of Annaly Capital Management
(NLY- NYSE), spoke to investors during his company's first quarter 2011 conference
call:

"[T]he change that is happening in the financial markets is a chaotic mess.
I believe the simultaneous execution of radical monetary policy, fiscal policy,
and financial regulatory reform is introducing rather than reducing systemic
risk in the global financial system by ignoring the simplest lesson of the
scientific method. Rather than change one variable in a complex system and
test the outcome, regulators and policymakers are changing virtually all of
them at the same time: QRM [quantitative risk management], risk retention,
the Volcker Rule, Basel III capital rules, derivatives clearing and related
margin requirements. GSE reform. FAS 166 and 167. Zero-bound fed funds policy
and QE2. Deficit financing, structural budgetary imbalances, and debt limit
debate."

Where will this end? Michael Lewitt, proprietor of Harch Capital Management
in Boca Raton, Florida, discussed the consequences of our leaders' catastrophic
policies in the May issue of his monthly letter, The Credit Strategist:

"Rather than confronting sources of volatility, policymakers have sought to
smooth out volatility at all costs. Unfortunately, these costs are proving
to be very high and will ultimately prove prohibitive. Pressures build inside
complex systems until they can no longer be suppressed. When these pressures
can no longer be contained, they tend to erupt with far greater violence than
had they been allowed to adjust earlier.

Lewitt continued. Federal Reserve Chairman Greenspan and Bernanke "convinced
investors the Fed would bail them out if the economy or markets got into serious
trouble. As a result, investors engaged in increasingly reckless behavior..." The
result: "Rather than saving the markets, Mr. Greenspan's philosophy and approach
guaranteed their failure." One of the consequences is "the build-up of unsustainable
debt levels."

We are overleveraged, undercollateralized, and accentuating these unsustainable
imbalances. Lewitt notes, "the Federal Reserve has accounted for 101 percent
of the net Treasury bond issuance during the first four months of 2011." He
goes on: "The U.S. government has been the largest purchaser of Treasuries,
promulgating a Ponzi scheme of unprecedented scale."

The U.S. Treasury issues debt and QE2 buys it. Lewitt notes that 10-year Treasury
yields have fallen from 3.59% on April, 11 2011, to 3.15% on May 6, 2011.

Since the Fed is the sole net buyer, the 10-year-yield is not a real interest
rate. (It has not been a true market for years, but never more so than now.)
This is also true of the zero-percent short-term yield, one of the trial balloons
listed by Michael Farrell. Interest rates are integral to the pricing of assets.
A country without an interest rate has a stock market with a price, but not
a value.

The future-focused investor should estimate the value of stocks, commodities,
and bonds as if interest rates were 5% higher. That day will come to pass:
when assets seek the price of their true collateral. This is not widely appreciated.
For instance, the recent dive in silver prices has been acclaimed as a bubble
that popped. That might be true, if paper contracts were worth the value they
purport to represent. There is not enough silver in the world to meet derivative
claims - of ETFs, forward contracts, and so on. When this misrepresentation
is widely recognized, physical silver will attract panic buying.

Silver is a fairly small market, so this may go unnoticed. That will be a
shame for the majority since everyone holds a paper claim that is not worth
the money it is written on. Dollar bills, still flowing forth from the Federal
Reserve (more exactly: from the U.S. Treasury's Bureau of Printing and Engraving),
are losing value every minute. Treasury securities are undercollateralized:
the Treasury spends $3 for every $2 it receives in tax payments.

What to do? One idea comes by way of footnote #8 in this month's The Credit
Strategist: "Readers interested in owning the Chinese currency can walk
into the Bank of China in New York or Los Angeles and open a remnimbi-denominated
account. While these accounts originally had limits on size, The Credit
Strategist understands that these limits have now been lifted and meaningful
amounts of money can be invested. These accounts are insured up to $250,000
by the FDIC (there must be some irony in that.)"

Sheehan serves as an advisor to investment firms and endowments. He is the
former Director of Asset Allocation Services at John Hancock Financial Services
where he set investment policy and asset allocation for institutional pension
plans. For more than a decade, Sheehan wrote the monthly "Market Outlook" and
quarterly "Market Review" for John Hancock clients.

Sheehan earned an MBA from Columbia Business School and a BS from the U.S.
Naval Academy. He is a Chartered Financial Analyst.